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By Frederic Bouchet, Ph.D.
Faculty Member, School of Business, American Public University
There has been a lot of debate about raising the minimum wage. Several states and some cities have made the decision to increase it significantly to make sure that minimum-wage workers are able to live decently. That is clearly not possible if the main breadwinner of a family of four earns $7.25 an hour, which is the current federal minimum wage.
Things are not always what they seem, however. A large minimum wage increase could end up hurting many of those people it is designed to help.
Consumer Prices versus the Law of Supply and Demand
Let’s first briefly consider the general role played by prices. Prices send signals to producers and consumers to guide them in their production and purchasing decisions. In markets that have no external restrictions, the equilibrium between supply and demand is reached by price adjustments.
For example, if there is too much quantity available compared to what consumers are willing to purchase, the price of those items declines until equilibrium is reached. In this situation, lower prices discourage some producers but entice some consumers to make purchases.
The law of supply and demand works in the opposite direction if the demand for a product is greater than the current supply of that product. Prices for that product will then increase, attracting new producers but discouraging some consumers and driving the market to equilibrium.
This adjustment mechanism keeps markets from experiencing shortages or surpluses for long periods of time. The situation would be different if prices could not adjust.
The Labor Market Is Also Connected to Supply and Demand
The labor market works the same way. Consider the market for unskilled labor. If there were no minimum wage laws, the wages paid to unskilled labor would be determined by supply and demand. In this case, demand represents the number of workers that companies are willing to hire at a specific wage and the supply is the number of people willing to work at that wage.
Now, if the number of people willing to work (supply) is greater than the number of people that firms want to hire (demand), the average wage (price) will have to drop for the market to reach equilibrium. That wage is called the market-clearing wage. At that point, there is no unemployment because everyone willing to work at that wage can find a job.
Of course, if the wage is not allowed to drop, the number of people willing to work would still remain greater than the number hired. That creates unemployment.
The minimum wage is what is called a price floor, since companies are not allowed to pay workers less than that amount. As long as the minimum wage is below the market clearing wage, there is no problem.
In this situation, a minimum wage would be useless because the market itself would find its equilibrium at a higher value. Firms would have to compete for low-skilled workers and increase the wages they pay, just as some firms have recently done.
Raising the Minimum Wage Would Also Increase the Supply of Minimum-Wage Workers
Some parts of the country have increased the minimum wage significantly. By the law of supply and demand — and the desire to improve one’s standard of living — the possibility of earning more money would attract more workers.
These workers might be people who had given up looking for work. They could also be people who decide that pursuing an education is not worth the effort since they can earn a sufficient income without going to school.
Whatever the reasons, the number of workers willing to work at that higher wage would increase. As a result, the supply of minimum wage workers would increase.
A Larger Minimum Wage Could Raise Business Costs and Product Prices
At the same time, any increase in the minimum wage means increased costs for businesses. So businesses have a couple of options:
- They can swallow the increase and reduce their profits if they are able. Some companies will do that.
- Those who cannot (or won’t) reduce their profit margin must either increase the price of their products or reduce their production costs.
The danger here is that a large number of firms that hire minimum-wage workers are in the retail and service industries. In most cases, these businesses have tight profit margins. That virtually eliminates the first option.
Many of these businesses — such as the fast-food industry — face a very elastic demand, which means that their customers are very price-sensitive. These businesses would be reluctant to increase their prices and would probably opt to reduce their labor costs instead.
That has happened as many industries have anticipated a minimum wage increase. That would create a situation whereby it would be financially advisable to replace salaried workers with computers or robots. The more the minimum wage increases, the more likely it is that robots will perform ever more complex tasks that once were done by humans.
Other options to reduce labor costs are to cut the number of hours people work or to relocate to a country with lower labor costs if the company’s activities allow it.
There Are Winners and Losers in a Minimum Wage Increase
Replacing workers with computers would seem to indicate that the anticipated minimum wage hike will place that wage significantly above the market clearing value. If that is the case, we can expect an increase in the number of unemployed for this category of workers.
Consequently, increasing the minimum wage produces winners and losers. The winners would be those workers with full-time jobs at the new minimum wage; the losers would be the increasing number of people who can find only part-time jobs at that wage or no jobs at all.
This situation is certainly not what the proponents of a minimum wage increase are hoping for. To be fair, there have been studies which show that small increases in the minimum wage do not significantly affect unemployment because most firms can adjust to the higher wage level. But that won’t be so in the case of the proposed large wage increases, as evidenced by the replacement of cashiers and factory jobs with robots or by automated ordering systems in restaurants.
Are we stuck then? If increasing the minimum wage to a level that allows people to earn a decent living creates unemployment, is there nothing that can be done?
An alternative to raising the minimum wage too high might arise if we remember that low-skilled jobs once were mostly for young people who could acquire self-confidence, good work habits, and skills that would make them more valuable to future employers. In other words, such jobs were supposed to be points of departure to open doors to better paying jobs down the road.
Providing targeted and practical training to help workers acquire specific skills that are in demand would seem to be an interesting alternative, too. But the motivation to improve oneself is likely lessened when workers see the minimum wage as sufficient to live on. That means minimum-wage jobs might become cul-de-sacs instead of avenues to a better life.
About the Author
Dr. Frederic Bouchet is an associate professor in the School of Business at American Public University. He holds an M.S. in math and economics from the Paris Institute of Technology for Life, Food and Environmental Sciences (AgroParisTech) as well as an M.S. and a Ph.D. in agricultural and applied economics from Virginia Polytechnic Institute and State University.
Dr. Bouchet was an economic and financial advisor for several private and nonprofit firms, primarily in the food industry sector, during the 18 years he lived in France. While there, he also served as the Chief Operating Officer for a network of European nonprofit organizations. Dr. Bouchet has taught mathematics and economics in the U.S. for the last 13 years.
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